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Evaluating 401(k) Plans in a House of Mirrors

Evaluating 401(k) Plans in a House of Mirrors

Every few months, a financial services company releases numbers touting the success of 401(k) plans. 401(k) account balances are higher than ever! 401(k) plans are working just fine! There is no retirement crisis!

However, like magicians, these firms don’t want you to see what's behind the numbers.

New reports from Fidelity Investments and the Vanguard Center for Retirement Research show that 401(k) balances have hit record highs. Fidelity says that the average 401(k) account balance has nearly doubled since March 2009, the stock market’s lowest point during the recession. Vanguard reports that the average 401(k) account balance is $101,650, the highest average since the company began tracking the figure in 1999. While these numbers sound promising, a few things are left out of the picture: 

Contributions vs. investment returns:  Account balances are bound to increase every year, simply because people continue to contribute to their 401(k) accounts – either because of inertia or because they have few other options when it comes to saving for retirement. These increases enable financial services companies to crow about “record highs” every year, even if the stock market takes a tumble.

According to Fidelity, 2/3 of the increase in its accounts was attributable to investment returns, 1/3 to contributions from workers and employers (Vanguard didn’t cite any percentages). However, in 2010, the ratio was flipped for Fidelity: contributions were responsible for 2/3 of the increase in account balances. In addition, it’s unlikely that investment gains were spread evenly among account holders (see “Median vs. average” below), so the numbers might give many people an overly optimistic impression of how well their investments are doing.

Median vs. average:  Industry studies use average figures, which means that a few really large account balances can skew the numbers and give a false impression of how much money most people have in their accounts.

The example cited in this NPR story illustrates the skewing effect of averages:

If you're in a bar and everybody in that bar has an income of $18,000 a year, and Bill Gates walks in to ask for directions, what happens to the average income in the bar? Well, it goes from $18,000 to, you know, $35 billion or something like that. And then you ask, all right, well why don't the people in the bar feel richer? Well, because none of their incomes has changed at all.

Indeed, the NPR story states that, for economists, the average “can be a misleading statistic.” That’s why impartial academic and government researchers generally use median – the number at which half of a population has less and half has more – when talking about account balances and income. Median account balances give a much more accurate reflection of what people have saved for retirement.

According to the 2012 Survey of Consumer Finances, the median account balance for all households is only $44,000. For those approaching retirement (ages 55-64), the median account balance is just $100,000 -- not much to live on in retirement.

The data set: Data from companies like Fidelity and Vanguard are derived from the accounts that they manage. Certainly those two companies are among the largest of the 401(k) providers, but does that necessarily mean that they are representative of the 401(k) universe in general? A recent press release from Judy Diamond Associates notes that, “the top 1% of plans hold 71.1% of all 401(k) assets.” If these companies hold a disproportionate share of those top plans, that would also skew the “average” account balance.

In her excellent dissection of 401(k) balances, Monique Morrissey of the Economic Policy Institute states, “[401(k)] assets are extremely concentrated at the top of the distribution and will not provide significant retirement income for the vast majority of Americans… [T]he existence of outsize account balances has no bearing on whether ordinary workers can rely on savings in these accounts to finance a decent retirement…” Furthermore, a recent poll by the Associated Press and the NORC Center for Public Affairs Research – two neutral organizations that don’t have a vested interest in the success of 401(k)s – shows that older workers are still delaying retirement due to the big losses in their 401(k)s.

When companies that profit from 401(k) plans declare those plans to be a great success, there’s probably some smoke and mirrors involved.

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